The Macroeconomist as Scientist and Engineer

American Economic Association
The Macroeconomist as Scientist and Engineer
Author(s): N. Gregory Mankiw
Source: The Journal of Economic Perspectives, Vol. 20, No. 4 (Oct., 2006), pp. 29-46
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Journal of EconomicPerspectives-Volume20, Number4-Fall 2006-Pages 29-46
The Macroeconomist as Scientist
and Engineer
N. Gregory Mankiw
Economists like to strike the pose of a scientist. I know, because I often do
it myself. When I teach undergraduates, I very consciously describe the
Economists
field of economics as a science, so no student will start the course thinking
that he or she is embarking on some squishy academic endeavor. Our colleagues in
the physics department across campus may find it amusing that we view them as
close cousins, but we are quick to remind anyone who will listen that economists
formulate theories with mathematical precision, collect huge data sets on individual and aggregate behavior, and exploit the most sophisticated statistical techniques to reach empirical judgments that are free of bias and ideology (or so we like
to think).
Having recently spent two years in Washington as an economic adviser at a
time when the U.S. economy was struggling to pull out of a recession, I am
reminded that the subfield of macroeconomics was born not as a science but more
as a type of engineering. God put macroeconomists on earth not to propose and
test elegant theories but to solve practical problems. The problems He gave us,
moreover, were not modest in dimension. The problem that gave birth to our
field-the Great Depression of the 1930s- was an economic downturn of unprecedented scale, including incomes so depressed and unemployment so widespread
that it is no exaggeration to say that the viability of the capitalist system was called
into question.
This essay offers a brief history of macroeconomics, together with an evaluation of what we have learned. My premise is that the field has evolved through the
efforts of two types of macroeconomists-those who understand the field as a type
of engineering and those who would like it to be more of a science. Engineers are,
first and foremost, problem solvers. By contrast, the goal of scientists is to underSN. GregoryMankiw is the RobertM. BerenProfessorof Economics,Harvard University,
Cambridge,Massachusetts.
30
Journal of EconomicPerspectives
stand how the world works. The research emphasis of macroeconomists has varied
over time between these two motives. While the early macroeconomists were
engineers trying to solve practical problems, the macroeconomists of the past
several decades have been more interested in developing analytic tools and establishing theoretical principles. These tools and principles, however, have been slow
to find their way into applications. As the field of macroeconomics has evolved, one
recurrent theme is the interaction-sometimes productive and sometimes notbetween the scientists and the engineers. The substantial disconnect between the
science and engineering of macroeconomics should be a humbling fact for all of us
working in the field.
To avoid any confusion, I should say at the outset that the story I tell is not one
of good guys and bad guys. Neither scientists nor engineers have a claim to greater
virtue. The story is also not one of deep thinkers and simple-minded plumbers.
Science professors are typically no better at solving engineering problems than
engineering professors are at solving scientific problems. In both fields, cuttingedge problems are hard problems, as well as intellectually challenging ones. Just as
the world needs both scientists and engineers, it needs macroeconomists of both
mindsets. But I believe that the discipline would advance more smoothly and
fruitfully if macroeconomists always kept in mind that their field has a dual role.
The Keynesian Revolution
The word "macroeconomics" first appears in the scholarly literature in the
1940s. To be sure, the topics of macroeconomics-inflation, unemployment, economic growth, the business cycle, and monetary and fiscal policy-have long
intrigued economists. In the eighteenth century, for example, David Hume (1752)
wrote about the short-run and long-run effects of monetary injections; at many
points, his analysis looks remarkably similar to what one might see from a modern
monetary economist or central banker. In 1927, Arthur Pigou published a book
titled IndustrialFluctuationsthat attempted to explain the business cycle. Nonetheless, the field of macroeconomics as a distinct and active area of inquiry arose in the
shadow of the Great Depression. There is nothing like a crisis to focus the mind.
The Great Depression had a profound impact on those who lived through it.
In 1933, the U.S. unemployment rate reached 25 percent, and real GDP was
31 percent below its 1929 level. All subsequent fluctuations in the U.S. economy
have been ripples on a calm sea compared to this tsunami. Autobiographical essays
by prominent economists of this era, such as Lawrence Klein, Franco Modigliani,
Paul Samuelson, Robert Solow, and James Tobin, confirm that the Depression was
a key motivating event in their careers (Breit and Hirsch, 2004).
The GeneralTheoryofJohn Maynard Keynes was the focal point in professional
discussions about how to understand these developments. All five of these Nobel
laureates confirm this from first-hand experience. Tobin reports the following
reaction from Harvard, where he was a student in the late 1930s and early 1940s:
"The senior faculty was mostly hostile .... The younger faculty and the graduate
N. GregoryMankiw 31
student teaching fellows were enthusiastic about Keynes's book." As is often the
case, the young had greater foresight than the old about the impact of the new
ideas. Keynes tied with Alfred Marshall as the most frequently cited economist in
economic journals in the 1930s and was the second most cited in the 1940s, after
Hicks (Quandt, 1976). This influence persisted for many years. Keynes ranked
number 14 in citations for the period from 1966 to 1986, even though he died two
decades before the time period began (Garfield, 1990).
The Keynesian revolution influenced not only economic research but also
pedagogy. Samuelson's classic textbook Economicswas first published in 1948, and
its organization reflected his perception of what the profession had to offer to the
lay reader. Supply and demand, which today are at the heart of how we teach
economics to freshmen, were not introduced until page 447 of the 608-page book.
Macroeconomics came first, including such concepts as the fiscal-policy multiplier
and the paradox of thrift. Samuelson wrote (on p. 253), "Although much of this
analysis is due to an English economist, John Maynard Keynes,... today its broad
fundamentals are increasingly accepted by economists of all schools of thought."
When a modern economist reads The GeneralTheory,the experience is both
exhilarating and frustrating. On the one hand, the book is the work of a great mind
being applied to a social problem whose currency and enormity cannot be questioned. On the other hand, although the book is extensive in its analysis, it
somehow seems incomplete as a matter of logic. Too many threads are left hanging.
The reader keeps asking, what, precisely, is the economic model that ties together
all the pieces?
Soon after Keynes published The GeneralTheory,a generation of macroeconomists worked to answer this question by turning his grand vision into a simpler,
more concrete model. One of the first and most influential attempts was the IS-LM
model proposed by the 33-year-old John Hicks (1937). The 26-year-old Franco
Modigliani (1944) then extended and explained the model more fully. To this day,
the IS-LM model remains the interpretation of Keynes offered in the most widely
used intermediate-level macroeconomics textbooks. Some Keynesian critics of the
IS-LM model complain that it oversimplifies the economic vision offered by Keynes
in The GeneralTheory.To some extent, this may well be true. The whole point of the
model was to simplify a line of argument that was otherwise hard to follow. The line
between simplifying and oversimplifying is often far from clear.
While theorists such as Hicks and Modigliani were developing Keynesian
models suitable for the classroom blackboard, econometricians such as Klein were
working on more applied models that could be brought to the data and used for
policy analysis. Over time, in the hope of becoming more realistic, the models
became larger and eventually included hundreds of variables and equations. By the
1960s, there were many competing models, each based on the input of prominent
Keynesians of the day, such as the Wharton model associated with Klein, the DRI
(Data Resources, Inc.) model associated with Otto Eckstein, and the MPS (MITPenn-Social Science Research Council) model associated with Albert Ando and
Modigliani. These models were widely used for forecasting and policy analysis. The
MPS model was maintained by the Federal Reserve for many years and would
32
Journal of EconomicPerspectives
become the precursor to the FRB/US model, which is still maintained and used by
Fed staff.
Although these models differed in detail, their similarities were more striking
than their differences. They all had an essentially Keynesian structure. In the back
of each model builder's mind was the same model taught to undergraduates today:
an IS curve relating financial conditions and fiscal policy to the components of
GDP, an LM curve that determined interest rates as the price that equilibrates the
supply and demand for money, and some kind of Phillips curve that describes how
the price level responds over time to changes in the economy.
As a matter of science, The General Theorywas a remarkable success. The
revolution that it inspired attracted many of the best young minds of its day. Their
prodigious output offered a new way to understand short-run economic fluctuations. Reflecting on these events, Samuelson (1988) offered a succinct summary:
"The Keynesian revolution was the most significant event in 20th-century economic
science." This sentiment is shared by many economists of his generation.
Yet the Keynesian revolution cannot be understood merely as a scientific
advance. To a large extent, Keynes and the Keynesian model builders had the
perspective of engineers. They were motivated by problems in the real world, and
once they developed their theories, they were eager to put them into practice. Until
his death in 1946, Keynes himself was heavily involved in offering policy advice. So,
too, were the early American Keynesians. Tobin, Solow, and Eckstein all took time
away from their academic pursuits during the 1960s to work at the Council of
Economic Advisers. The Kennedy tax cut, eventually passed in 1964, was in many
ways the direct result of the emerging Keynesian consensus and the models that
embodied it.
The New Classicals
By the late 1960s, cracks in the Keynesian consensus were starting to appear.
Those cracks would grow into fissures, which would eventually crumble the macroeconomic consensus and undermine confidence in the mainstream econometric
models. In its place, a more classical view of the economy would reemerge.
The first wave of new classical economics was monetarism, and its most notable
proponent was Milton Friedman. Friedman's (1957) early work on the permanent
income hypothesis was not directly about money or the business cycle, but it
certainly had implications for business cycle theory. It was, in part, an attack on the
Keynesian consumption function, which provided the foundation for the fiscal
policy multipliers that were central to Keynesian theory and policy prescriptions. If
the marginal propensity to consume out of transitory income is small, as Friedman's
theory suggested, then fiscal policy would have a much smaller impact on equilibrium income than many Keynesians believed.
Friedman and Schwartz's (1963) MonetaryHistoryof the UnitedStateswas more
directly concerned with the business cycle and it, too, undermined the Keynesian
consensus. Most Keynesians viewed the economy as inherently volatile, constantly
The Macroeconomist
as Scientistand Engineer 33
buffeted by the shifting "animal spirits" of investors. Friedman and Schwartz
suggested that economic instability should be traced not to private actors, but
rather to inept monetary policy. The implication was that policymakers should be
satisfied if they do no harm by following simple policy rules. Although Friedman's
proposed rule of steady growth in monetary aggregates has few adherents today, it
was an early precursor to the inflation-targeting regimes now in effect in many of
the world's central banks.
Friedman's Presidential Address to the American Economic Association in
1968, along with Phelps (1968), took aim at the weakest link in the Keynesian
model: the Phillips curve trade-off between inflation and unemployment. At least
since Samuelson and Solow (1960), some sort of Phillips curve had been part of the
Keynesian consensus, even if not a view endorsed by Keynes himself. Samuelson
and Solow (1960) understood the theoretical tenuousness of this trade-off, and
their paper was filled with caveats about why the short-run and long-run trade-off
could differ. But the subsequent literature forgot those caveats all too easily. The
Phillips curve provided a convenient way to complete the Keynesian model, which
always had trouble explaining why prices failed to equilibrate markets and how the
price level adjusted over time.
Friedman argued that the trade-off between inflation and unemployment
would not hold in the long run, when classical principles should apply and money
should be neutral. The trade-off appeared in the data because, in the short run,
inflation is often unanticipated and unanticipated inflation can lower unemployment. The particular mechanism that Friedman suggested was money illusion on
the part of workers. More important for the development of macroeconomics was
that Friedman put expectations on center stage.
This prepared the way for the second wave of new classical economics-the
rational expectations revolution. In a series of highly influential papers, Robert
Lucas extended Friedman's argument. In his "Econometric Policy Evaluation: A
Critique," Lucas (1976) argued that the mainstream Keynesian models were useless
for policy analysis because they failed to take expectations seriously; as a result, the
estimated empirical relationships that made up these models would break down if
a new policy were implemented. Lucas (1973) also proposed a business cycle theory
based on the assumptions of imperfect information, rational expectations and
market clearing. In this theory, monetary policy matters only to the extent to which
it surprises people and confuses them about relative prices. Barro (1977) offered
evidence that this model was consistent with U.S. time-series data. Sargent and
Wallace (1975) pointed out a key policy implication: Because it is impossible to
surprise rational people systematically, systematic monetary policy aimed at stabilizing the economy is doomed to failure.
The third wave of new classical economics was the real business cycle theories
of Kydland and Prescott (1982) and Long and Plosser (1983). Like the theories of
Friedman and Lucas, these were built on the assumption that prices adjust instantly
to clear markets-a radical difference from Keynesian theorizing. But unlike the
new classical predecessors, the real business cycle theories omitted any role of
monetary policy, unanticipated or otherwise, in explaining economic fluctuations.
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Journal of EconomicPerspectives
The emphasis switched to the role of random shocks to technology and the
intertemporal substitution in consumption and leisure that these shocks induced.
As a result of the three waves of new classical economics, the field of macroeconomics became increasingly rigorous and increasingly tied to the tools of
microeconomics. The real business cycle models were specific, dynamic examples
of Arrow-Debreu general equilibrium theory. Indeed, this was one of their main
selling points. Over time, proponents of this work have backed away from the
assumption that the business cycle is driven by real as opposed to monetary forces,
and they have begun to stress the methodological contributions of this work. Today,
many macroeconomists coming from the new classical tradition are happy to
concede to the Keynesian assumption of sticky prices, as long as this assumption is
imbedded in a suitably rigorous model in which economic actors are rational and
forward-looking. Because of this change in emphasis, the terminology has evolved,
and this class of work now often goes by the label "dynamic stochastic general
equilibrium" theory. But I am getting ahead of the story.
At the time the three new classical waves were first hitting shore in the 1970s
and 1980s, one of their goals was to undermine the old Keynesian macroeconometric models both as a matter of science and as a matter of engineering. In their
article "After Keynesian Macroeconomics," Lucas and Sargent (1979) wrote, "For
policy, the central fact is that Keynesian policy recommendations have no sounder
basis, in a scientific sense, than recommendations of non-Keynesian economists or,
for that matter, noneconomists." Although Sargent and Lucas thought Keynesian
engineering was based on flawed science, they knew that the new classical school
(circa 1979) did not yet have a model that was ready to bring to Washington: "We
consider the best currently existing equilibrium models as prototypes of better,
future models which will, we hope, prove of practical use in the formulation of
policy." They also ventured that such models would be available "in ten years if we
get lucky." I will return later to the question of whether this prospect panned out
as they had hoped.
As these quotations suggest, those engaged in the new classical movement were
neither shy about their intentions nor modest about their accomplishments. Lucas
offered an even more blunt assessment in a 1980 article entitled "The Death of
Keynesian Economics": "One cannot find good, under-forty economists who identify themselves or their work as 'Keynesian'. Indeed, people even take offense if
referred to as 'Keynesians'. At research seminars, people don't take Keynesian
theorizing seriously anymore; the audience starts to whisper and giggle to one
another." Yet just as Lucas was writing the eulogy for Keynesian economics, the
profession was about to welcome a generation of "new Keynesians."
The New Keynesians
Economists attracted to the Keynesian approach to the business cycle have
long been discomfited by the issue of microfoundations. Indeed, a 1946 article by
Lawrence Klein, one of the first to use the term "macroeconomics," begins as
N. GregoryMankiw 35
follows: "Manyof the newly constructed mathematical models of economic systems,
especially business-cycle theories, are very loosely related to the behavior of individual households or firms which must form the basis of all theories of economic
behavior." All modern economists are, to some degree, classical. We all teach our
students about optimization, equilibrium, and market efficiency. How to reconcile
these two visions of the economy-one founded on Adam Smith's invisible hand
and Alfred Marshall's supply and demand curves, the other founded on Keynes's
analysis of an economy suffering from insufficient aggregate demand-has been a
profound, nagging question since macroeconomics began as a separate field of
study.
Early Keynesians, such as Samuelson, Modigliani, and Tobin, thought they had
reconciled these visions in what is sometimes called the "neoclassical-Keynesian
synthesis." These economists believed that the classical theory of Smith and Marshall was right in the long run, but the invisible hand could become paralyzed in
the short run described by Keynes. The time horizon mattered because some
prices-most notably the price of labor-adjusted sluggishly over time. Early Keynesians believed that classical models described the equilibrium toward which the
economy gradually evolved, but that Keynesian models offered the better description of the economy at any moment in time when prices were reasonably taken as
predetermined.
The neoclassical-Keynesian synthesis is coherent, but it is also vague and
incomplete. While the new classical economists responded to these defects by
rejecting the synthesis and starting afresh, the new Keynesian economists thought
there was much to preserve. Their goal was to use the tools of microeconomics to
give greater precision to the uneasy compromise reached by early Keynesians. The
neoclassical-Keynesian synthesis was like a house built in the 1940s: The new
classicals looked at its outdated systems and concluded it was a tear-down, while the
new Keynesians admired the old-world craftsmanship and embraced it as an opportunity for a major rehab.
The first wave of research that can rightly be called "new Keynesian"is the work
on general disequilibrium (Barro and Grossman, 1971; Malinvaud, 1977). These
theories aimed to use the tools of general equilibrium analysis to understand the
allocation of resources that results when markets do not clear. Wages and prices
were taken as given. The focus was on how the failure of one market to clear
influences supply and demand in related markets. According to these theories, the
economy can find itself in one of several regimes, depending on which markets are
experiencing excess supply and which are experiencing excess demand. The most
interesting regime-in the sense of corresponding best to what we observe during
economic downturns-is the so-called "Keynesian"regime in which both the goods
market and the labor market are exhibiting excess supply. In the Keynesian regime,
unemployment arises because labor demand is too low to ensure full employment
at prevailing wages; the demand for labor is low because firms cannot sell all they
want at prevailing prices; and the demand for firms' output is inadequate because
many customers are unemployed. Recessions and depressions result from a vicious
circle of insufficient demand, and a stimulus to demand can have multiplier effects.
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Journal of EconomicPerspectives
The second wave of new Keynesian research aimed to explore how the concept
of rational expectations could be used in models without the assumption of market
clearing. To some extent, this work was responding to Sargent and Wallace's (1975)
conclusion of monetary policy irrelevance by showing how systematic monetary
policy could potentially stabilize the economy, despite rational expectations
(Fischer, 1977). To some extent, it was motivated by a desire to find an empirically
realistic model of inflation dynamics (Taylor, 1980). The Achilles heel of this work
was that it assumed a form of labor contracts that, while perhaps justifiable on
empirical grounds, was hard to square with microeconomic principles.
Because so much of the Keynesian tradition was based on the premise that
wages and prices fail to clear markets, the third wave of new Keynesian research
aimed to explain why this was the case. Various hypotheses were explored: that
firms face "menu costs" when they choose to change their prices; that firms pay
their workers "efficiency wages" above the market-clearing level to increase worker
productivity; and that wage and price setters deviate from perfect rationality.
Mankiw (1985) and Akerlof and Yellen (1985) pointed out that when firms have
market power, there are large differences between the private and social costbenefit calculations regarding price adjustment, so a sticky-price equilibrium could
be privately rational (or near rational) while socially very costly. Blanchard and
Kiyotaki (1987) showed that part of this divergence between private and social
incentives results from an aggregate-demand externality: when one firm cuts its
prices, it increases real money balances and thus the demand for the products of all
firms. Ball and Romer (1990) established that there is strong complementary
between real and nominal rigidities, so any motive for avoiding relative-price
changes would exacerbate the sluggishness of nominal prices.
In retrospect, these various new Keynesian contributions were more related
and complementary than they seemed at the time, even to people working on
them. For example, it is tempting to see the early work on general disequilibrium
as a dead end-a research program that sowed the seeds of its own demise by its
assumption of predetermined prices. Indeed, this work rarely finds its way on to
reading lists today. Yet one can also see a progression of related ideas about how the
economy works when prices do not move instantly to balance supply and demand.
There is, for instance, an interesting but rarely noticed relationship between
the first and third waves of new Keynesian economics. In particular, one can view
the third wave as establishing the centrality of the Keynesian regime highlighted in
the first wave. When firms have market power, they charge prices above marginal
cost, so they alwayswant to sell more at prevailing prices. In a sense, if all firms have
some degree of market power, then goods markets are typically in a state of excess
supply. This theory of the goods market is often married to a theory of the labor
market with above-equilibrium wages, such as the efficiency-wage model. In this
case, the "Keynesian"regime of generalized excess supply is not just one possible
outcome for the economy, but the typical one.
In my judgment, these three waves of new Keynesian research added up to a
coherent microeconomic theory for the failure of the invisible hand to work for
short-run macroeconomic phenomena. We understand how markets interact when
The Macroeconomist
as Scientistand Engineer 37
there are price rigidities, the role that expectations can play, and the incentives that
price setters face as they choose whether or not to change prices. As a matter of
science, there was much success in this research (although, as a participant, I
cannot claim to be entirely objective). The work was not revolutionary, but it was
not trying to be. Instead, it was counterrevolutionary: its aim was to defend the
essence of the neoclassical-Keynesian synthesis from the new classical assault.
Was this work also successful as a matter of engineering? Did it help policymakers devise better policies to cope with the business cycle? The judgment here
must be less positive-a topic to which I will return shortly.
But it is remarkable that the new Keynesians were, by temperament, more
inclined to become macroeconomic engineers than were economists working
within the new classical tradition. Among the leaders of the new classical school,
none (as far as I know) has ever left academia to take a significant job in public
policy. By contrast, the new Keynesian movement, like the earlier generation of
Keynesians, was filled with people who traded a few years in the ivory tower for a stay
in the nation's capital. Examples include Stanley Fischer, Larry Summers, Joseph
Stiglitz,Janet Yellen, John Taylor, Richard Clarida, Ben Bernanke, and myself. The
first four of these economists came to Washington during the Clinton years; the
last four during the Bush years. The division of economists between new
classicals and new Keynesians is not, fundamentally, between the political right
and the political left. To a greater extent, it is a split between pure scientists and
economic engineers.
Digression and Vitriol
The theory and empirics of long-run economic growth are beyond the scope
of the essay, but it is worth pointing out that these topics occupied much of the
attention of macroeconomists during the decade of the 1990s. This work drew
attention away from short-run fluctuations, which had dominated the field of
macroeconomics since its birth half a century earlier.
There are several reasons for the emergence of growth as a major area for
research. First, a series of influential papers by Paul Romer (1986) and others
offered a new set of ideas and tools for analyzing what is surely one of the most
compelling topics in economics-the large gap between rich and poor nations.
Second, new cross-country data became available that allowed systematic examination of the validity of alternative theories (Summers and Heston, 1991). Third, the
U.S. economy in the 1990s was experiencing its longest expansion in history.Just as
the early Keynesians were attracted to the field because of its immediate relevance
to the nation's health, the economy of the 1990s suggested to that generation of
students that the business cycle was no longer of great practical importance.
There is also a fourth, more troublesome reason why budding macroeconomists of the 1990s were drawn to study long-run growth rather than short-run
fluctuations: the tension between new classical and new Keynesian worldviews.
While Lucas, the leading new classical economist, was proclaiming that "people
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Journal of EconomicPerspectives
don't take Keynesian theorizing seriously anymore," leading Keynesians were
equally patronizing to their new classical colleagues. In his Presidential Address to
the American Economic Association, Solow (1980) called it "foolishly restrictive"
for the new classical economists to rule out by assumption the existence of wage
and price rigidities and the possibility that markets do not clear. He said, "I
remember reading once that it is still not understood how the giraffe manages to
pump an adequate blood supply all the way up to its head; but it is hard to imagine
that anyone would therefore conclude that giraffes do not have long necks."
In an interview with Arjo Klamer (1984) a few years later, Lucas remarked, "I
don't think that Solow, in particular, has ever tried to come to grips with any of
these issues except by making jokes." In his own interview in the same volume,
Solow explained his unwillingness to engage with the new classical economists:
"Suppose someone sits down where you are sitting right now and announces to me
that he is Napoleon Bonaparte. The last thing I want to do with him is to get
involved in a technical discussion of cavalry tactics at the Battle of Austerlitz. If I do
that, I'm getting tacitly drawn into the game that he is Napoleon Bonaparte."
To some extent, this dispute reflects the differing perspectives of the protagonists about the goal of the field. Lucas seems to be complaining that Solow does
not appreciate the greater analytic rigor that new classical macroeconomics can
offer. Solow seems to be complaining the Lucas does not appreciate the patent lack
of reality of his market-clearing assumptions. They each have a point. From the
standpoint of science, the greater rigor that the new classicals offered has much
appeal. But from the standpoint of engineering, the cost of this added rigor seems
too much to bear.
I dwell on the nature of this debate not only because it reflects the underlying
tension between scientists and engineers but also because it helps explain the
choices made by the next generation of economists. Such vitriol among intellectual
giants attracts attention, much in the way that the patrons in a bar gather around
a fistfight, egging on the participants. But it was not healthy for the field of
macroeconomics. Not surprisingly, many young economists chose to avoid taking
sides in this dispute by turning their attention awayfrom economic fluctuations and
toward other topics.
A New Synthesis, or a Truce?
An old adage holds that science progresses funeral by funeral. Today, with the
benefits of longer life expectancy, it would be more accurate (if less vivid) to say
that science progresses retirement by retirement. In macroeconomics, as the older
generation of protagonists has retired or neared retirement, it has been replaced by
a younger generation of macroeconomists who have adopted a culture of greater
civility. At the same time, a new consensus has emerged about the best way to
understand economic fluctuations. Marvin Goodfriend and Robert King (1997)
have dubbed this consensus view "the new neoclassical synthesis." This synthesis
model has been widely applied in research on monetary policy (Clarida, Gali, and
N. GregoryMankiw 39
Gertler, 1999; McCallum and Nelson, 1999). The most extensive treatment of this
new synthesis is Michael Woodford's (2003) monumental (in both senses of the
word) treatise.
Like the neoclassical-Keynesian synthesis of an earlier generation, the new
synthesis attempts to merge the strengths of the competing approaches that preceded it. From the new classical models, it takes the tools of dynamic stochastic
general equilibrium theory. Preferences, constraints, and optimization are the
starting point, and the analysis builds up from these microeconomic foundations.
From the new Keynesian models, it takes nominal rigidities and uses them to
explain why monetary policy has real effects in the short run. The most common
approach is to assume monopolistically competitive firms that change prices only
intermittently, resulting in price dynamics sometimes called the new Keynesian
Phillips curve. The heart of the synthesis is the view that the economy is a dynamic
general equilibrium system that deviates from a Pareto optimum because of sticky
prices (and perhaps a variety of other market imperfections).
It is tempting to describe the emergence of this consensus as great progress. In
some ways, it is. But there is also a less sanguine way to view the current state of play.
Perhaps what has occurred is not so much a synthesis as a truce between intellectual
combatants, followed by a face-saving retreat on both sides. Both new classicals and
new Keynesians can look to this new synthesis and claim a degree of victory, while
ignoring the more profound defeat that lies beneath the surface.
The heart of this new synthesis-a dynamic general equilibrium system with
nominal rigidities-is precisely what one finds in the early Keynesian models. Hicks
proposed the IS-LM model, for example, in an attempt at putting the ideas of
Keynes into a general equilibrium setting. (Recall that Hicks won the 1972 Nobel
Prize jointly with Kenneth Arrow for contributions to general equilibrium theory.)
Klein, Modigliani, and the other model builders were attempting to bring that
general equilibrium system to the data to devise better policy. To a large extent, the
new synthesis picks up the research agenda that the profession abandoned, at the
behest of the new classicals, in the 1970s.
With the benefit of hindsight, it is clear that the new classical economists
promised more than they could deliver. Their stated aim was to discard Keynesian
theorizing and replace it with market-clearing models that could be convincingly
brought to the data and then used for policy analysis. By that standard, the
movement failed. Instead, they helped to develop analytic tools that are now being
used to develop another generation of models that assume sticky prices and that, in
many ways, resemble the models that the new classicals were campaigning against.
The new Keynesians can claim a degree of vindication here. The new synthesis
discards the market-clearing assumption that Solow called "foolishly restrictive"and
that the new Keynesian research on sticky prices aimed to undermine. Yet the new
Keynesians can be criticized for having taken the new classicals' bait and, as a result,
pursuing a research program that turned out to be too abstract and insufficiently
practical. Paul Krugman (2000) offers this evaluation of the new Keynesian
research program: "One can now explain how price stickiness could happen. But
useful predictions about when it happens and when it does not, or models that
40
Journal of EconomicPerspectives
build from menu costs to a realistic Phillips curve, just don't seem to be forthcoming." Even as a proponent of this line of work, I have to admit that there is some
truth to that assessment.
The View from Central Banking
If God put macroeconomists on earth to solve practical problems, then Saint
Peter will ultimately judge us by our contributions to economic engineering. So
let's ask: Have the developments in business cycle theory over the past several
decades improved the making of economic policy? Or, to set a more modest goal,
have the advances in macroeconomic science altered how economic policy is
analyzed and discussed among professional economists who are involved in the
policy process?
One place to find evidence to answer these questions is Laurence Meyer's
charming memoir A Termat the Fed. In 1996, Meyer left his job as an economics
professor at Washington University and as a prominent economic consultant to
serve for six years as a governor of the Federal Reserve. His book provides a window
into how economists at the highest reaches of monetary policymaking view their
jobs and the approaches they take to analyzing the economy.
The book leaves the reader with one clear impression: recent developments in
business cycle theory, promulgated by both new classicals and new Keynesians, have
had close to zero impact on practical policymaking. Meyer's analysis of economic
fluctuations and monetary policy is intelligent and nuanced, but it shows no traces
of modern macroeconomic theory. It would seem almost completely familiar to
someone who was schooled in the neoclassical-Keynesian synthesis that prevailed
around 1970 and has ignored the scholarly literature ever since. Meyer's worldview
would be easy to dismiss as outdated if it were idiosyncratic, but it's not. It is typical
of economists who have held top positions in the world's central banks.
It is fashionable among academics to believe that central banking has been
strongly influenced by the rules-versus-discretion literature, particularly the work
on time inconsistency that started with Kydland and Prescott (1977). Two institutional changes are often linked with these academic contributions: the increased
independence of central banks in countries such as New Zealand and the adoption
of inflation targeting as a policy regime in many central banks around the world.
These institutional changes, in turn, are then linked to improvements in monetary
policy. According to this line of argument, Kydland and Prescott are to be thanked
for the low, stable inflation that many countries have enjoyed over the past two
decades.
This self-congratulatory view runs into two problems. First, the institutional
changes we have observed are at best loosely connected to the issues raised in the
theoretical literature. An independent central bank is not the same as a rule-bound
central bank. The U.S. Federal Reserve has long had a high degree of independence without ever committing itself to a policy rule. Even inflation targeting is
closer to a statement of intentions and a way of communicating with the public than
The Macroeconomist
as Scientistand Engineer 41
it is a commitment to a policy rule. Bernanke (2003) has called it "constrained
discretion."
The second, more significant problem is that these institutional changes are
not necessarily linked to the improvements we have witnessed in monetary policy.
Ball and Sheridan (2005) look at a large sample of countries and show that
adoption of inflation targeting does not help explain the recent move toward low,
stable inflation. Monetary policy has improved both in those counties that have
adopted inflation targets and in those that have not. This worldwide improvement
in inflation outcomes could be because the world economy has not had to deal with
supply shocks as adverse as those experienced in the 1970s or because central
bankers have learned from the experience of the 1970s that high inflation should
be assiduously avoided. But the evidence shows that inflation targeting is not a
prerequisite for good monetary policy.
The Federal Reserve under Alan Greenspan is a case in point. According to
Blinder and Reis (2005), Greenspan has a rightful claim to be "the greatest central
banker who ever lived." Indeed, by most accounts, monetary policy worked remarkably well under his leadership. Yet throughout his time at the helm of the Fed,
Greenspan avoided any announcement of a policy rule, valuing flexibility over
commitment. Here is how Greenspan (2003) defended his choice: "Some critics
have argued that such an approach to policy is too undisciplined--judgmental,
seemingly discretionary, and difficult to explain. The Federal Reserve should,
some conclude, attempt to be more formal in its operations by tying its actions
solely to the prescriptions of a formal policy rule. That any approach along these
lines would lead to an improvement in economic performance, however, is highly
doubtful....
Rules by their nature are simple, and when significant and shifting
uncertainties exist in the economic environment, they cannot substitute for riskmanagement paradigms, which are far better suited to policymaking." Yet, despite
Greenspan's aversion to policy rules, inflation was low and stable during his tenure
as Fed chairman. Greenspan proves that central banks can produce desirable
outcomes while wielding substantial discretionary powers.
The View from Fiscal Policy
Another place to look for the practical impact of macroeconomic theory is the
analysis of fiscal policy. The Bush tax cuts of 2001 and 2003 offer a good case study,
in part because they are a recent attempt at a major fiscal stimulus to combat a
recession and in part because, as chairman of the Council of Economic Advisers for
two years, I am familiar with much of the economic analysis that laid the foundation
for this policy. To be sure, there were many motives for the design of the Bush tax
policy. The expansion of the child tax credit, for example, was rooted as much in
politics and social philosophy as it was in economics. But economists at the Council
of Economic Advisers and Treasury had substantial input into the development of
the policy, so it is illuminating to consider the tools they brought to the job.
42
Journal of EconomicPerspectives
The economic analysis of the Bush tax plan was done with one eye on long-run
growth and one eye on the short-run business cycle. The long-run perspective
would be familiar to students of public finance. Most significantly, in 2003 Bush
proposed eliminating the double taxation of income from corporate capital. The
final bill passed by Congress did not fully achieve this goal, but the substantial cut
in tax rates on dividends moved in the direction of greater tax neutrality, reducing
the bias for retained earnings over dividends, the bias for debt over equity finance,
and the bias for noncorporate over corporate capital. It also moved the tax code
further in the direction of taxing consumption rather than income. This latter goal
is consistent with a well-established literature in public finance (for example,
Diamond and Mirrlees, 1971; Atkinson and Stiglitz, 1976; Feldstein, 1978; Chamley,
1986) and is not particularly new as a matter of economic theory. Three decades
ago, Atkinson and Stiglitz noted, even then, there was a "conventional presumption
in favor of consumption rather than income taxation."
More relevant to this essay, however, is the short-run analysis of tax policy. As
President George W. Bush took office in 2001, the economy was heading into a
recession after the bursting of the stock market bubble of the late 1990s. One goal
of the tax cuts was to stimulate economic recovery and employment. When Bush
signed the Jobs and Growth Tax Relief Reconciliation Act of 2003, he explained the
policy as follows: "When people have more money, they can spend it on goods and
services. And in our society, when they demand an additional good or a service,
somebody will produce the good or a service. And when somebody produces that
good or a service, it means somebody is more likely to be able to find a job." This
logic is quintessentially Keynesian.
The Council of Economic Advisers was asked to quantify how tax relief would
affect employment. We answered this question using a mainstream macroeconometric model. The specific model we used while I was there was the one maintained
by Macroeconomic Advisers, the consulting firm created and run by Laurence
Meyer before he was a Federal Reserve governor. This model was being used by the
staff of the Council of Economic Advisers long before I arrived as chairman and, in
fact, had been used for almost two decades under both Republican and Democratic
administrations. The choice of this particular model is not crucial, however, for the
Macroeconomic Advisers model is similar to other large macroeconometric models, such as the FRB/US model maintained by the Federal Reserve. From the
standpoint of intellectual history, these models are the direct descendents of the
early modeling efforts of Klein, Modigliani and Eckstein. Research by new classicals
and new Keynesians has had minimal influence on the construction of these
models.
The real world of macroeconomic policymaking can be disheartening for
those of us who have spent most of our careers in academia. The sad truth is that
the macroeconomic research of the past three decades has had only minor impact
on the practical analysis of monetary or fiscal policy. The explanation is not that
economists in the policy arena are ignorant of recent developments. Quite the
contrary: the staff of the Federal Reserve includes some of the best young Ph.D.s,
N. GregoryMankiw
43
and the Council of Economic Advisers under both Democratic and Republican
administrations draws talent from the nation's top research universities. The fact
that modern macroeconomic research is not widely used in practical policymaking
is prima facie evidence that it is of little use for this purpose. The research may have
been successful as a matter of science, but it has not contributed significantly to
macroeconomic engineering.
Inside
the Classroom
Beyond the corridors of power in the world's capitals, there is another place
where the economics profession tries to sell its wares to a broader audience-the
undergraduate classroom. Those of us who regularly teach undergraduates see our
job as producing citizens who are well-informed about the principles of good
policy. Our choice of material is guided by what we see as important for the next
generation of voters to understand.
Like policymakers, undergraduates typically have little interest in theory for
theory's sake. Instead, they are interested in understanding how the real world
works and how public policy can improve economic performance. Except for the
rare student who is considering graduate school and a career as an academic
economist, the undergraduate has the perspective of an engineer, more than that
of a scientist. It is, therefore, useful to take note of what we choose to teach
undergraduates. And there is no better place to see what we teach than in the
contents of the most widely used undergraduate textbooks.
Consider, for example, the books used to teach intermediate-level macroeconomics. A generation ago, the three leading texts for this course were those by
Robert Gordon; Robert Hall andJohn Taylor; and Rudiger Dornbusch and Stanley
Fischer. Today, the top three sellers are those written by Olivier Blanchard; Andrew
Abel and Ben Bernanke; and myself. The common thread is that each of these six
books was written by at least one economist with graduate training from MIT, a
prominent engineering school where the dominant macroeconomic tradition was
that of Samuelson and Solow. In all these books, the basic theory taught to
undergraduates is some version of aggregate demand and aggregate supply, and
the basic theory of aggregate demand is the IS-LM model. The same lesson can be
gleaned by perusing the most widely used textbooks for freshman-level economics:
short-run economic fluctuations are best understood using some version of the
neoclassical-Keynesian synthesis.
I do not mean to suggest that pedagogy has been stagnant as the field has
evolved. Today's textbooks place greater emphasis on classical monetary theory,
models of long-run growth, and the role of expectations than did those of 30 years
ago. There is less confidence about what policy can accomplish and more emphasis
on policy rules over discretionary monetary and fiscal actions (despite the lack of
evidence on the practical importance of policy rules). But the basic framework that
modern students learn to make sense of the business cycle is one that would be
familiar to an early generation of Keynesians.
44
Journal of EconomicPerspectives
The exception that proves the rule is the intermediate text written by Robert
Barro, first published in 1984. Barro's book provided a clear and accessible introduction to the new classical approach to macroeconomics aimed at undergraduates. Keynesian models were included, but they were covered late in the book,
briefly, and with little emphasis. When the book came out, it received substantial
attention and acclaim. However, while many macroeconomists read the Barro book
and were impressed by it, many fewer chose it for their students. The new classical
revolution in pedagogy that Barro hoped to inspire never took off, and the Barro
text did not offer significant competition to the dominant textbooks of the time.
This lack of revolution in macroeconomic pedagogy stands in stark contrast to
what occurred half a century ago. When Samuelson's introductory textbook was
first published in 1948 with the aim of introducing undergraduates to the Keynesian revolution, the world's teachers rapidly and heartily embraced the new approach. By contrast, the ideas of new classicals and new Keynesians have not
fundamentally changed how undergraduate macroeconomics is taught.
Not a Dentist in Sight
John Maynard Keynes (1931) famously opined, "If economists could manage
to get themselves thought of as humble, competent people on a level with dentists,
that would be splendid." He was expressing a hope that the science of macroeconomics would evolve into a useful and routine type of engineering. In this future
utopia, avoiding a recession would be as straightforward as filling a cavity.
The leading developments in academic macroeconomics of the past several
decades bear little resemblance to dentistry. New classical and new Keynesian
research has had little impact on practical macroeconomists who are charged with
the messy task of conducting actual monetary and fiscal policy. It has also had little
impact on what teachers tell future voters about macroeconomic policy when they
enter the undergraduate classroom. From the standpoint of macroeconomic engineering, the work of the past several decades looks like an unfortunate wrong turn.
Yet from the more abstract perspective of macroeconomic science, this work
can be viewed more positively. New classical economists were successful at showing
the limitations of the large Keynesian macroeconometric models and the policy
prescriptions based on these models. They drew attention to the importance of
expectations and the case for policy rules. New Keynesian economists have supplied
better models to explain why wages and prices fail to clear markets and, more
generally, what types of market imperfections are needed to make sense of shortrun economic fluctuations. The tension between these two visions, while not always
civil, may have been productive, for competition is as important to intellectual
advance as it is to market outcomes.
The resulting insights are being incorporated into the new synthesis that is now
developing and which will, eventually, become the foundation for the next generation of macroeconometric models. For those of us interested in macroeconomics
The Macroeconomist
as Scientistand Engineer 45
as both science and engineering, we can take the recent emergence of a new
synthesis as a hopeful sign that more progress can be made on both fronts. As we
look ahead, "humble" and "competent" remain ideals toward which macroeconomists can aspire.
* I am grateful to Steven Braun, James Hines, Donald Marron, David Romer,Andrei
Shleifer,TimothyTaylor,Michael Waldman,and Noam Yuchtmanfor helpfulcomments.
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